Why Invest in Bonds?

The bond market is not glamorous. When the economy is going strong, you’ll rarely hear talk at parties or read articles about the hottest bonds or bond funds. However, for the conservative portion of your portfolio, bonds are usually among the best investment choices.

Bonds are essentially a means in which you lend companies or the government money for a period of time. The due date is the maturity of the bond. During the time that the money is borrowed, or the life of the bond, the bondholder earns interest for having purchased the bond, or loaned the money. Bonds can be purchased at face value or at either a discount or a premium, depending on the interest rate of the bond and the bond market. Essentially, if general interest rates rise above the rate of your bond, your bond decreases in value. Conversely, if general rates drop below the rate of your bond, your bond increases in value.

While stocks and equity mutual funds will be more lucrative in the long run, bonds are more dependable for capital preservation. Typically, unless a company goes bankrupt, your initial investment is safe. And you’ll know if a company is in trouble because corporate (as well as municipal) bonds are rated based on the dependability of the company to pay back the loan. Government bonds are the safest of all investments, backed by the full faith and credit of the U.S. government.

If you are looking for a steady stream of income, bonds are a means of achieving that goal. Receiving steady interest at set intervals can provide cash flow or additional income, which can be beneficial, especially for a retired couple or individual.

Bonds can also have large tax advantages. You can buy tax-free government or municipal bonds. While they do not pay a particularly high rate of return, they can be advantageous when looking to minimize your total tax liability.

For someone seeking a low-risk investment that can be useful for an upcoming expenditure, zero coupon bonds can be helpful. These bonds are sold at a substantial discount from their face amount. However, you need to be patient, because there is only one payment and that is at maturity. The payment is higher than you would receive from periodic interest — it is equal to the purchase price (the principal) plus the total interest earned, compounded semiannually at the original interest rate. By staggering several zero coupon bonds, also known as "laddering" them, you can use such bonds effectively for major expenditures like the ongoing payments of college tuition or even car payments.

The amount of your portfolio devoted to bonds will depend on how much risk you are willing to take, your investing goals and current needs, plus economic conditions. At different times you will want to move more money into the safer bonds market, particularly when approaching times in life where you cannot afford to be in high-risk investments. So, use the bonds wisely, as they can be a very important part of your portfolio.